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'Fiscal Cliff' as the New Y2K? Threats May Be Overstated

By Michael Santoli, Yahoo! Finance

Is Wall Street freaking out too much about the "fiscal cliff"?

Joel Carillet | Getty Images

It has appeared that way at times in the week since President Barack Obama's re-election cast urgent attention on the need for a budget compromise before $600 billion in automatic tax increases and spending cuts kicks in.

Here's a handy way to determine what might cause financial markets to overreact to an approaching event: figure out what economic surprise last made a number of smart people feel stupid for having underestimated its potential for market mayhem.

The last episode that humbled many astute economists and investors was the standoff in Congress in the summer of 2011 over raising the nation's borrowing limit. Debt-ceiling votes were widely viewed as procedural necessities, and the notion of inviting a potential government default was unthinkable to rational analysts, leading them to assume cooler heads would prevail.

Santoli: Fade The Fiscal Cliff Freakout?

Of course, the mutual stubbornness of the party leaders sparked a credit-agency downgrade of the United States, and the ensuing market tantrum dropped the Dow 2,000 points in three months — blindsiding both the Washington and Wall Street consensus. (Read more: Markets Still Waiting for Breakthrough on 'Fiscal Cliff'.)

As a result, perhaps, too much of the foreboding discussion of the "fiscal cliff" treats it as a daunting suspense movie. Alternatively, the markets either see it as a light at the end of the tunnel, or the headlight of an oncoming train. (Read more: Bartiromo: 'Fiscal Cliff' Deal? Don't Count on It.)

Separating the amorphous threat into its essential elements, though, gives a clearer view of whether market panic makes sense. There are three issues to focus on:

Recession Risk

In too many places, it's being taken as a given that the $50 billion or so in monthly effects of the full fiscal contraction would trigger a recession. Rampantly repeated estimates from the Congressional Budget Office are for a 3% reduction in economic output if the maximum effects were in place for all of 2013. Yet this is an exceedingly unlikely outcome, given the elements of agreement about extending or finding ways around many of the expiring provisions.

Michael Darda, chief market strategist at MKM Partners, points out that no U.S. recession in the past 100 years has occurred without the Federal Reserve constricting the money supply by either higher interest rates or other means. Tighter money is certainly not an element of today's economy, and likely won't be anytime soon, even though rates are already near zero.

(Read more: "Fed Might Target Rate Guidance to Data, Not Dates: Yellen.")

Due to nonproductive talks in Washington, there is also evidence that businesses have already anticipated a potential slowdown, curtailing spending on plants and equipment as a result.

This would mean some of the pain has been front-loaded. If a palatable budget compromise is forged, it may uncork pent-up demand early next year. JPMorgan Chase Chief Executive Jamie Dimon hinted at this prospect last week, when he suggested "the economy can boom" if the fiscal issues are sufficiently addressed.

Like a steep rise in gasoline prices, the bump in payroll and income taxes would pressure spending across the economy, and reduce its cushion against another recession — but by no means would it guarantee one would occur.

IHS economist Nigel Gault this week issued a "worst-case scenario" for the economy, amounting to a 1.7% decline in U.S. output in 2013. However, this is based on not only the full fiscal-cliff impact, but also a breakup of the euro zone, an oil spike from renewed Middle East hostilities, and a significant slowdown in China.

If all that happens in the coming months, panic would certainly be warranted. Still, there's a reason it's called a "worst case."

Fiscal Abyss?

When the public becomes consumed with typically arcane economic and federal budget matters, it often means the underlying crisis has peaked. In the early 1990s, the deficit anxiety that propelled Ross Perot to 19 percent of the presidential popular vote climaxed, even as the country was about to reap a huge disarmament "peace dividend". Meanwhile, the economy was gathering strength for a multi-year growth streak.

Similarly, the preoccupation in 2008 with a "peak oil" resource shortage that produced the campaign applause line of "Drill, baby, drill," came just as North American energy supplies were surging and oil prices fell.

While the country has far more debt today, both in absolute terms and relative to the economy's size, the deficit as a proportion of the economy reached its maximum above 10% in 2009, and has been shrinking ever since. The huge, immediate budget imbalance has a great deal to do with the severe depth of the 2008-'09 recession.

CBO: Federal Budget Deficit for Fiscal 2012 $1.1 Trillion

Furthermore, the U.S. government spends only slightly more in absolute dollars on interest on its debt annually than it did in the mid-1990s, thanks to rock-bottom borrowing rates. Also, debt service is a small sliver of total spending.

This doesn't mean the $1 will close on its own, but there is more time to arrive at a long-term structural budget solution than is generally perceived.

The Tax-Hike Threat

When the debate hinges on whether taxes on high-earning Americans will rise less than four percentage points, and capital-gains taxes five points, it's hard to take certain predictions seriously. It calls into question whether this is a decisive swing factor, in either economic-growth incentives or investment returns.

The trench across which this war is being waged is so narrow that inevitably, both sides systematically overstate the impact of the contemplated changes. Republicans are over-invested in suggesting that nudging up tax rates for high earners to 1990s levels would sap the small-business expansion.

This amounts to claiming a small-business owner who believes a new worker would generate a profit for the company would hire that person if the owner had 65 percent of the profit over $250,000 a year left over after federal taxes are deducted, but not if the after-tax take were 60.5 percent.

Likewise, Democrats are eager to point to boosting taxes on the wealthy as a significant help in closing the deficit, when in the short term it would make only a small dent in the budget gap. Longer-term, however, having higher rates on large incomes and investment gains could accelerate deficit reduction in a faster-growing economy, as it did in the '90s. That would be more of a secondary benefit.

Taxes also appear overplayed as a factor in investment decisions and market performance. Echoing several academic studies, O'Shaughnessy Asset Management ran through the history of increases in income, dividend and capital-gains taxes, and found no consistent relationship between tax-rate changes and subsequent stock market returns.

There's no denying that the prospect of elected leaders acting capriciously offers plenty to worry about. And perhaps an ultimate compromise will only come as a result of an anticipated market freak-out.

Yet based on reasonable assessments of the impact, there's a decent chance that a more benign economic outcome is likely. Barring a dramatic turn, that could make lots of experts and investors feel silly in a few months time once the fiscal cliff issue has run its course.